Occasionally, you will see an ad placed in the financial section of the classifieds indicating that someone has a trust deed they wish to sell. Trust deeds are the recorded document securing a note on a piece of real estate. People selling a note have two problems! First, they are generally aware that they will take a discount off the unpaid note balance to get the cash they need. Additionally, if they carried this note when they sold a property other than their personal residence, in which case part of the gain may be tax free, they will also trigger a capital gain and a corresponding tax liability. Sometimes people are so pressed for cash they forget this second aspect of selling a note and are very unhappy at tax time.

        For a real estate investor, this much motivation frequently spells opportunity. The investor will make a cash offer on the note at a discounted figure that delivers the desired return for the risk being assumed. If the investor decides a return of 12% is sufficient yield on a first note position on an owner occupied home, provided there is a 20% equity behind his encumbrance, he makes his calculations and prepares an offer. Suppose a note like this is available for sale whose unpaid loan balance is $105,000, amortized over 30 years and payable at $731.83 per month including interest at 7%. All the payments have been made on time for the last 4 years and the property is worth $145,000 in today's market. To obtain the desired yield the note buyer makes an offer of $69,900.97.

        This can be a terrific deal for all the partied involved. The note seller gets cash today for the emergency or opportunity he has found. The note buyer gets the note rate of 7% on $105,000, or interest in the approximate amount of $7350 in the first year. That amount of interest is being earned by an investment of $69,900 for an interest rate returned of 10.5%. If return of principle is included in the payments, then the return becomes 12%! Spectacular returns in a 2 to 4% marketplace for cash held in a bank account.

THE DOWNSIDE

Q. What if the note is not a first but a second note? Or the property is non-owner occupied or even vacant land?

A. The experienced investor will determine how much increased risk each one of those factors represents and increases the yield accordingly, offering less for the note. For instance the same note bought at an 18%-yield would cost $48,319.94. Of course, any note buyer willing to accept the same risk at a lower yield would offer more and probably win the bid, but at all times the first, best and most likely buyer for the note would be the payor who could refinance the property to buy back their own note. Too often the most interested party is overlooked, and this may cost a note seller thousands of dollars!

Q. Why would someone sell a note if they take such a discount?

A. Sometimes an opportunity comes along to double or triple your money in a short period of time. Some people are willing to take such a chance and the discount amount is offset by their anticipated profit. Sometimes the need is urgent enough that a discount doesn't matter. However, if the note holder's credit is still good, we can sometimes get full face value for a note by using it as a down payment on real estate and then refinancing out the cash that is needed. This formula then produces both a real estate acquisition and often the return of the initial investment capital to the IRA.

        The particular advantage to acquiring a real estate security and moving it forward in real estate is that we are both creating the capital gain and conducting activities normally assigned to real estate dealers in a tax free, tax deferred environment. This accelerates your capital growth by as much as 48%, assuming the normal real estate dealer is in the 28% tax bracket and must also pay self-employment tax over 15%!

Next month, we will discuss personal property conversions in real estate.